Living off your investments is the ultimate goal of financial independence (FI) and the trickiest part to get right. This phase is known as decumulation and it’s the part of the journey I’m about to embark on.
My objective is simple:
- Drawdown enough income so that Mrs Accumulator and I can live without needing to work.
- Maintain a decent quality of life.
- Not run out of money before we die.
The key is to allow plenty of margin for error.
Our decumulation plan needs to cope with volatile market conditions, flawed assumptions, and the fifth law of thermodynamics: Grit happens.
What I’ll present – over three detailed articles – is our genuine, all-our-skin-in-the-game plan to meet this challenge.
This is no longer theoretical for me and Mrs A..
It’s the rest of our life.
My plan rests on the best practical research I’ve found over many years, fitted to our personal situation.
It’s resistant to the main threats that bedevil many decumulation strategies:
I’ve built in multiple safety features. But I know there are no guarantees.
Decumulation: time to get personal
My plan’s core components will be relevant to other decumulators, FIRE-ees, and near-retirees, regardless of our different circumstances.
Customisation is critical though, so here’s a list of our particulars:
- Time horizon: 45 years
- Chance we both live another 45 years: 8%
- Decumulation method: annual withdrawals based on a sustainable withdrawal rate (SWR) from a portfolio of volatile assets such as equities and bonds.
- Capital preservation required: No
- Legacy required: No
- Back-up sources of income: State Pensions due in approximately 18 years. Small Defined Benefit (DB) pension for Mrs A in the future. Ability to work if required, or as desired.
- Inheritance: No
I’ve decided not to share our personal numbers. This plan scales regardless of wealth or income. I’ve left clues all over the Internet, anyway.
It may be helpful to know that we got here on relatively modest five-figure salaries and plan to live on less than the annual median household income.
That’s quite tight, which is why the plan is bold in some respects.
I’d love to take a ‘safety-first’ retirement approach. To rely more heavily on less volatile instruments such as defined benefit pensions, annuities, and index-linked government bonds.
Sadly, that route is unaffordable for us. But it’s definitely worth investigating if you have greater means.
My final, overriding, set-up point: my job has been fairly all-consuming for more than two decades. I’d like to live a fuller life now.
That entails risk.
That’s life though, so I’ll try to offset the risk via:
- Multiple back-up plans
- Awareness of the failure points
- Conservative assumptions
- Not believing this is fire-and-forget
Living life now means not waiting until we can live off the dividends or fund a conservative 3% SWR.
But a naive 4% SWR is too risky, in my view.
So how can I use more sophisticated decumulation techniques to deploy our wealth more effectively, without turning retirement into a decades-long tightrope act?
The first step is understanding what an acceptable failure rate is.
Failure is negotiable
Standard SWR studies define failure too narrowly.
If the simulated portfolio’s wealth hits zero before the end of its time horizon then it’s a fail.
But we humans can run out of life before we run out of money. If I flatline before my wealth does then… success!
Well, sure. Kinda. Sorta.
The point is that SWR failure rates are less risky when you factor in your own mortality.
If Mrs A and I have a 10% chance of both being alive in 45 years, and our portfolio has a 10% chance of giving up the ghost in that time (at our chosen SWR) then our actual failure rate is:
0.1 x 0.1 x 100 = 1% chance of running out of money and both of us being alive to worry about it.
That’s a 99% success rate! Always look on the bright side of death.
I’m assuming here that the portfolio will more easily support one person than two.
That matters, because there’s a 49% chance that at least one of us will be around in 45 years.
One person won’t be able to live half as cheaply as two, but the portfolio will definitely last longer if it isn’t financing my chocolate habit.
The upshot is I’m comfortable picking a higher SWR – based on a 10% failure rate – when it’s twinned with a reasonable life expectancy for both of us.
Remember, we only stand an 8% chance of both being around in 45 years, so I’m still choosing an optimistic life expectancy. There’s a 2% chance we’re both here in 50 years time.
Also, SWR sims don’t account for humans noticing when the bank balance is draining at an alarming rate.
In real life people put the spending brakes on years before their portfolio sparks out. (More on this later.)
SWR research is generally based on single-country portfolios split fifty-fifty between equities and conventional government bonds.
In a nutshell, US-based historical studies may be too optimistic. But non-US studies don’t account for the contemporary advantages of global diversification.
Research into asset-class diversification generally shows a modest uptick in SWR.
As a UK investor I’m not going to bank on history repeating the stellar US asset returns of the past century.
But I’m happy that a diversified global portfolio could replicate historical developed world returns. Those were scarred by two world wars, after all.
Here’s my de-accumulation asset allocation:
Growth – 60%
- 20% World equities
- 15% World multi-factor (Size, Value, Quality, Momentum)
- 10% UK equities
- 10% Emerging Market equities
- 5% REITS
(Note: there’s approximately 2% more UK exposure in the World funds.)
Defensive – 40%
- 15% UK gilts (long, intermediate, and short durations)
- 15% World index-linked government bonds (Hedged to £, short duration)
- 5% cash (currently it’s 10%)
- 5% gold (I don’t own this yet)
Most of my holdings are in cheap index trackers, though I will use active funds when I don’t have a good passive investing alternative.
I won’t use high-yield funds because I think that a total return strategy beats an income investing strategy.
Decumulation portfolio rationale
Here’s a short (ish) explanation of my decumulation portfolio choices. Happy to debate any of it in the comments after.
The expected returns of our equity holdings should provide the real returns we need to sustain our income over the decades. A strong equity allocation along with our State Pensions is our best protection against longevity risk.
It’s that or troughing out on deep-fried Mars Bars and cigarettes for the next 30 years. YOLO!
Adding a multi-factor holding to my equity split increases diversification at the price of higher fees, mitigated by the hope of slightly higher returns. This is debatable, optional, and may well be a slim hope.
The volatility of equity returns exposes us to sequence of returns risk. That is the chance that a poor run of market conditions sends our portfolio into a death spiral we can’t escape.
Another threat is high inflation whittling away the value of our defensive assets over the long-term.
Our defensive assets reduce our sequence of returns risk – as well as the stress of watching our main income source collapse during a market crash.
Conventional government bonds are likely to outperform other assets during a steep market decline.
Short duration bonds and cash guard against rising interest rates but they are much less effective than longer bonds when equities bomb.
(Cash sometimes outperforms bonds, especially in inflationary scenarios. It’s also easier to get change from a tenner than a 10-year gilt at Tesco.)
Index-linked government bonds are best against runaway inflation. Equities do badly in these scenarios. Equity inflation protection asserts itself in the medium to long-term, but linkers can pay your bills today.
We’ll hold linkers and conventional bonds in a 50:50 ratio.
Structural problems with the UK’s index-linked gilt market explain why I use developed world linkers.
For conventional bonds, choose a global government bond fund or total global bond market fund if you prefer. Just make sure it’s hedged to the £ (to eliminate currency risk) and that it’s overwhelmingly concentrated in high-quality bonds.
Match your bond fund’s duration to your time horizon to reduce interest rate risk.
Gold is a wild card that can perform when nothing else works. It’s typically uncorrelated to other assets and, in recent years, has spiked when people think the financial system is circling the drain.
I see gold as a one-shot wonder. It’s a shotgun blast in the face of some crisis occurring during the first 10-15 years of decumulation.
That early period is when we’re most exposed to sequence of returns risk. After that gold will be discarded like an empty weapon because its long-term returns are poor.
Does the age of negative interest rates, QE, and government bazookas mean we’re in for secular stagnation, rampant inflation, or stagflation on steroids?
Your guess is as good as the next clairvoyant. I’ll hedge my bets with that mix of equities, linkers, and gold.
In times past, I’d probably have been 50:50 split across bonds:equities on the eve of decumulation. Now I won’t go below 60% equities. I believe I can tolerate the extra risk.
If I couldn’t handle this large (ish) equity allocation, I’d need a bigger portfolio to sustain the same income. I believe high equity valuations and low to negative bond yields heighten the risk of anaemic returns over the next 10 to 15 years.
A diversified portfolio in itself is only worth a small SWR raise, so I’ll also use a dynamic asset allocation strategy to try to squeeze a bit more juice out of my pot. This means my equity allocation could hit 100% if the market stays down for years.
Before I check out
In my next post I’ll explain how I plan to employ dynamic allocation – and dynamic withdrawals – to finesse my plans. Subscribe to make sure you see it.
Take it steady,
The Accumulator (though not for much longer)